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Indonesia has just given the go-ahead for another leg down in the rupiah. It has cut its forecasts for the exchange rate to 9,700 per dollar compared to the 9,200 level at which the central bank used to step in. The currency has duly weakened and nervous foreigners have rushed to hedge exposure — 3-month NDFs price the rupiah at almost 10,000 to the dollar. The rupiah last week hit a three-year low, its weakness coming on top of a dismal 2012 which saw it fall 6 percent as the current account deficit worsened. Traders in Jakarta are reporting dollar hoarding by exporters.

All that is spooking foreigners who own more than 30 percent of the domestic bond market. The currency weakness hit them hard last year as Indonesian bonds returned just 6 percent, a third of the sector’s 16 percent average (see graphic).

The central bank does not seem perturbed by the currency weakness. Luckily for it, inflation rates are still benign, which means a weak currency will probably remain in favour.

The big question is how will investors react?

A test will come on Tuesday, when the government will try to raise $724 million via an auction of domestic bonds and T-bills. There has been some flight by bond investors in recent days but most have stayed put – after all they are earning a 5-6 percent carry on bonds and currency exposure can be hedged. Above all, people are betting the central bank is capable of stemming any big falls in the currency. (They are probably right: Deputy Governor Hartadi Sarwono assured investors last week that if the rupiah weakened too much, the bank would “definitely respond to it via interest rate policy”). UBS strategist Manik Narain points out the central bank has $112 billion in its coffers while interest rates are at a record low 5.75 percent:

The central bank has a considerable arsenal. They haven’t even started to raise rates yet and if we were to see some monetary tightening, investors will quickly pay attention and come back. They can also deploy some of their considerable reserves.

Positioning should also help. Foreigners’ underweights on Indonesian bonds and currency hit 7-year highs at the end of 2012, according to JPMorgan’s monthly survey. That level of underweight positioning is costly to sustain for too long, given Indonesia is among the highest carry credits in Asia, JPM analysts say. They went overweight Indonesian bonds late last year.

Lastly, Indonesia’s current account deficit is around 2.4 percent of gross domestic product — a far cry from Turkey where the funding gap is close to 10 percent. A weak currency should help rein that in. ButTim Condon, ING’s Asia FX strategist reckons a deficit of this magnitude may not be a bad thing for Indonesia at all:

We expect the deficits to persist as a rising investment rate outstrips national saving. This was the case before the Asian crisis when Indonesia ran current account deficits on the order of 2% to 3% of GDP. We see a rising investment rate driving GDP growth back to the pre-Asian crisis 7-8% pace.